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Book title: Understanding Financial Markets & Instruments
Author: Braam van den Berg

Chapter 5: The foreign exchange market

5.1   Introduction 
5.2   The determination of the foreign exchange rate 
5.3  Transaction exposure to a foreign currency 
5.4  Hedging foreign exchange exposures 
5.4.1  Hedging in the forward market 
5.4.2  Hedging in the money market 
5.4.3  Hedge in the options market 
5.4.4  Hedging in the futures market 
5.4.5  Leading and lagging 
5.5  The government and exchange control 

5.1  Introduction

The foreign exchange market is the market where currencies of different countries are traded.  Because different countries in the world buy goods and services from one another, the different currencies change hands between countries.   If South Africa, for instance, buys vehicles from the USA, we would need US $ to pay for them.  We would then buy US $ from the foreign exchange market, paying with South African rand.

A loan of money could also be made between two countries, and the loan plus interest must then be paid back in the currency of the country that lent the money to the other country.  In general, foreign currency can be described as all cash held and claims payable in a currency other than that of the local country.

There would be a demand for the currency of a country that exports goods.  The foreign currency market is also a market where demand and supply plays their parts, but there are other factors to consider in this market, which are not present in other markets.  Some of these factors will be discussed in this chapter.

5.2   The determination of the foreign exchange rate

In the forex market the price mechanism is expressed in terms of an exchange rate.  The price that a person would pay for another currency is expressed by one of two methods of quotation:

The direct method:
The price of one foreign currency in terms of the domestic currency, for example, in South Africa, the following would be a direct quote:
US $1 = R5,00

The indirect method:
The price of one domestic currency in terms of the foreign currency, for example, in South Africa, the following would be an indirect quote:
R1,00 = US $0,20

The price of one foreign currency could also be expressed in terms of another foreign currency, and this is referred to as a cross rate, for  example, for a South African the following would be a cross rate between US $ and British pounds (sterling):
GBP 1,00 = US $1,60

As pointed out above, the forex market is a normal market with supply and demand of goods (in this case currencies), but there are other factors such as inflation, the purchasing power of money and interest rates that play a major role in determining the rate at which two currencies are traded.

Examples that will illustrate some of the effects of other factors will now be discussed.

If the following scenario applies between the USA and RSA:  US $1 = SA R1, and if the price of one loaf of white bread is R1 in South Africa and in America $1, then there is equilibrium in the theoretical purchasing power of the currencies.

If the price of a loaf of white bread in South Africa increases to R1,10 because of other factors in the market, such as the increasing cost of production, the exchange rate should change in order to avoid arbitrage opportunity.

If the exchange rate does not change accordingly, this would mean that an American could buy a loaf of white bread in America for $1, sell it in South Africa for R1,10  exchange the R1,10 for $1,10 and make a $0,10 profit without risk.   American bread producers can then export white bread to South Africa and make a profit because of the price difference.  This would, however, result in an increased demand for dollars, and to reach a point of equilibrium again, the exchange rate must change to US $1 = R1,10.

If, on  the other hand, the short-term interest rate in South Africa were 15% whereas the short-term interest rate in America is only 10%, an investor would rather invest his money in South Africa (ignoring risk differences).  In this case, an investor investing R100 would at the end of one year receive R115 if he invested in South Africa, and $110 if he invested in America.  If the exchange rate is US $1 = R1, there is an arbitrage opportunity.  Money could be borrowed in America (say $100), paying an interest rate of 10%, and invested in South Africa receiving an interest rate of 15%.  At the end of one year a risk-free $5 profit can be made if the exchange rates stays the same (receiving R115 on the investment in South Africa and only paying $110 for the loan in America).  In order for equilibrium to exist, R115 must at the end of the year be equal in value to $110.  This would result in an exchange rate of US $1 = R1,045.

In most cases, though, the exchange rate is determined by, among other things, a combination of the purchasing power parity and the difference in interest rates in countries.  Because of exchange control measures whereby a country protects its resources, money and goods cannot be bought, sold, invested and taken out as freely and simply as in the above examples.

If it is assumed, due to restrictions, that costs and other factors, money is kept in the country of origin, the combination of purchasing power parity and interest rates can be illustrated.  If the same interest rates as above are assumed and you invest R100 in RSA and US  $100 in the US for a year, you will have the following after one year:

  • In RSA, R115
  • In USA, $110

According to purchasing power parity, these amounts (which were the same at the beginning of the year) should be able to buy the same goods at the end of the year.  If bread in RSA is R1,10 and in the US $1,00, you should be able to buy the same quantity of bread with your R115 in RSA that an American can buy in USA with his $110.

In the RSA you can buy R115/R1,10 loaves of bread = 104,55 loaves of bread.

To be able to buy 104,55 loaves of bread in America, you will need:

$1  =  R115/$104,55

$1  =  R1,10

5.3  Transaction exposure to a foreign currency

When a South African business imports goods from America, he has to pay the supplier in US $.  As with all large transactions there is normally a credit period or term of payment that allows the purchaser to pay for the goods a few months after goods have been delivered.  If the payment term is three months, the purchaser in South Africa has a choice:

  • He can buy US $ now and pay for the goods immediately.  The US $ would then cost him an amount using the current exchange rate in the spot market.
  • He can wait three months and buy US $ after three months to pay for the purchase.  To buy US $ he would have to pay an amount using the exchange rate which is traded in three months' time.

If the purchaser chooses the second option of paying for the purchase in three months' time only, there is a risk to the purchaser that the exchange rate would alter in such a way that US $ would cost him much more in three months' time than it would at current rates.  This exposure is known as a transaction exposure to the purchaser, and can be managed in certain ways.

Similarly there is a risk to the seller if he only receives his money in three months' time, that the exchange rate could alter so that he receives less than he would have received at current rates.

5.4  Hedging foreign exchange exposures

There are several methods available in the market to hedge transaction exposures.  The following methods will be briefly discussed:

  • Hedging in the forward market
  • Hedging in the money market
  • Hedging in the options market
  • Hedging in the futures market
  • Making use of leading and lagging.

5.4.1  Hedging in the forward market

A South African company who knows that it will need US $100 000 in three month's time to pay for a purchase, can go to a bank (or any forex dealer approved by the South African Reserve Bank) and close a forward contract with the bank.  A forward contract is a contract whereby the bank promises to sell to the company US $100 000 at an exchange rate determined in the contract at the time of closing the contract.

The company thus fixes the amount that it will pay for US $100 000 in three month's time by closing the contract now, and fixing an exchange rate in the contract.  The exchange rate stated in the contract is known as a forward exchange rate.  No money changes hands between the two parties at the closing of the contract.

The bank determines the forward rate in the contract in the following manner:

The bank now takes on the foreign exchange exposure and has to cover this risk.  It must have US $100 000 in three months' time to give to the company.   Because it is an approved foreign exchange dealer, the bank can buy US $ now and place it on deposit at a US bank, to ensure that it has US $100 000 in three months' time.

The bank, however, does not have to buy the full US $100 000 now, as it will receive interest (say the US deposit rate is 10%) for the three months on the deposit at the US bank.  The bank therefore only buys:

$100 000             
1 + (iUS x t / 365)


iUS  =  short-term deposit rate in the US

T      =  term of deposit

The bank thus buys:  $100 000                 
                                    1 + (0,10 x 90 / 365)

                                     = $97 594

To buy $97 594 now, the bank must pay rand at the current exchange rate (say the current exchange rate is $1 = R5,00).

The bank thus pays:  $97 594 x 5,00

                                    = R487 970

The bank must borrow the R487 970 it needs to purchase US $ at the current short-term interest rate in South Africa for three months (or at the cost of capital of the bank if it uses internal funds).  If the current short-term interest rate in South Africa is 15%, the bank will have to pay:

R487 970 x 15% x 90/365 interest in three months time to the lender

=  R18 048

This interest paid by the bank will be borne by the company and will be discounted in the forward rate.

The total cost to the bank for this transaction is thus

The cost of the US $ loan R487 970
Plus the interest on the loan R  18 048
Total cost R506 018

The forward rate is then calculated by the total cost divided by the amount in US $ of the contract:

R506 018/$100 000

= R5,0602

The forward rate in the contract would thus be:

US $1 = R5,0602

The forward rate is often quoted by giving the forward points.  The forward points consist of the difference between the spot (current) rate and the forward rate:

5,0602 - 5,000

= 0,0602

= 60,2 points

A term that is used in the market to compare different methods is the "cost of cover".  The cost of cover for a forward transaction is calculated as:

Forward points    x    365                     
Spot rand rate     x    term     x     100

    0,0602   x     365                
=  5,000     x      90    x    100

= 4,88%

5.4.2  Hedging in the money market

For reasons of exchange control, corporate companies cannot keep foreign currency for an unlimited period.  It must convert the foreign currency into rand within a certain time.  The companies therefore cannot construct their own forward deal in the money market.

An exporter can, however, hedge in the money market if foreign money is owing to him, if, for instance, an exporter will receive $100 000 in three months' time for a sale, and he is of the opinion that $100 000 will be worth less in rand in three months' time than at spot (current) rates, he can do the following:

Borrow $100 000 less the interest thereon for three months now.   Convert $ to rand at the current rate.  Use the payment that he will receive in three months' time for the sale to repay the loan.

5.4.3  Hedge in the options market

An importer can buy a $ call option which gives him the right to buy $ in the future at a rate determined at closing of the contract.  Detail of options will be discussed in chapter 7.

Similarly an exporter can buy a put option to hedge his risk.

5.4.4  Hedging in the futures market

In 1997 the South African Futures Exchange (SAFEX) where granted the right to trade in R/$ futures.  Members of SAFEX who are authorised foreign exchange dealers can trade in these futures on SAFEX.  Institutional investors would thus have to trade through authorised dealers.  The working of futures will be discussed in chapter 6.

The last option in managing forex exposures is to stay unhedged and accept the risk that the exchange rate movement may have a negative impact on your financial position.

5.4.5  Leading and lagging

A technique called leading and lagging can be used where payments are received and made in foreign currencies.  In the case of the local currency depreciating against foreign currencies, a business would want to pay their foreign debts immediately (called leading) to avoid having to pay more at a later stage when the currency has depreciated.  This business would also want to postpone receipts in foreign currency as long as possible (called lagging) so that the foreign amount receivable is worth more in local currency terms at receipt, because of the depreciating local currency.  The change in foreign exchange control regulations in 1998 allowing companies to keep their foreign currency for 180 days, gives South African companies the opportunity to actively make use of the leading and lagging technique.

5.5  The government and exchange control

As stated in the opening chapter of this book, the government of a country has a responsibility to protect the resources of its country.  Because goods are traded and paid for across borders, one of the ways which governments use to protect the country is to instigate foreign exchange control through foreign exchange regulation.

Foreign exchange and the dealing therein used to be heavily regulated in South Africa mainly because of political circumstances.  Many of these measures were abolished during the past few years, although significant measures still remain.

The restrictions on non-residents have largely fallen away which means that they can invest and withdraw their money at will, subject to certain minor limitations.

Residents and South African companies are, however, still rather heavily regulated in certain aspects.  Investments abroad cannot be made at will, and in 1998 private individuals were allowed to invest a maximum of R400 000 abroad.   To accommodate this change and day-to-day transactions for corporate clients, the government scrapped the foreign exchange cash limits, which could be held by authorised foreign exchange dealers.  Institutional investors may swap South African assets (such as listed shares, etc.) for foreign assets for up to a maximum of 15% of their total assets (1998).

Exchange control measures that are still in place are being phased out by the government in co-operation with the Reserve Bank in such a way that there is no massive flight of capital out of the country.


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